Question

Today is April 1st. A bank needs to borrow $100

million on May 15th by selling 90-day Eurodollar deposits. Bank’s

Treasury desk is looking into derivatives contracts for hedging the

bank’s risk and is interested in the June Eurodollar futures contract

with a current price of 93.25 and a contract size of $1 million.

Explain the risk faced by the bank in the spot market and determine the

futures position that the Treasury desk should take in order to hedge

against the risk.

On May 15, LIBOR rate and the Eurodollar futures contract rate

both are equal to 5 percent. Assuming that the Treasury desk constructs the

hedge position you have identified in part (a), CALCULATE the hedged and

unhedged effective cost of borrowing for your bank. EXPLAIN whether the

hedge was a mistake.

Answer 1

a) In the spot market, bank faces the risk of dollar increasing after three months. It is looking to hedge using eurodollar futures. So treasury should buy eurodollar futures to hedge against the risk.

b) Amount to be borrowed = $100 million.

Current price of futures is 93.25. Then implied interest rate is 100-93.25=6.75%.

Contract size = $1 million

So 100 eurodollar futures are needed.

If contract rate=5% on 15th May, profit on futures = 100 * 1 * (6.75-5)% = $1.25 milliom

Interest payable on $100 million borrowed = $100 million * 5%= $ 5 million

Net cost of borrowing = 5-1.25 = $3.75 million

Effective cost of borrowing = 3.75/100*100=3.75%

But if hedging had not been done, then cost of borrowing would have been higher at 5% .

Thus it was right decision to hedge using eurodollar futures and was not a mistake.